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Submitted by Viktor Shvets, head of global equity strategy at Macquarie

Between Dante and a Hard Place

‘Abandon all hope, you who enter here’, Dante Alighieri, Divine Comedy (1308-1321)

According to Dante’s ‘Divine Comedy’, there was a mountain in the Southern Hemisphere where people needed to proceed through a purification process that removed some of their earthly sins, and according to Dante, the mountain consisted of seven terraces that encompassed seven sins (pride, envy, wrath, sloth, avarice, gluttony and lust). It was only after going through seven levels that souls finally arrived at an earthly paradise on top of the mountain.

In some ways, we feel that today’s equity investors are in a similar position. Most investors understand that buying at the top of EPS cycles and at historically high multiples, is probably a modern version of avarice (or extreme greed for wealth) and possibly gluttony, tinged with envy. The same applies to blindly following numbers while taking announcements that problems have been fixed for granted (e.g. ‘Trade war was placed on Hold’, ‘Macron Saved the World’, etc) as invitations to forget the context and get on with life, assuming that politics solve geopolitics and Central Banks fix economies (is it a sin of sloth?). Neither Dante nor the Catholic Church have ever been specific as to how long it takes to go through the circles and how many times one might need to turn back, and we believe that the same uncertainty bedevils today’s investors.

Sectoral rotations – nowhere to hide and inconsistent rotations…

Since late January 2018, equity markets have experienced regular tremors, as investors started to assess the impact of central banks’ (CBs) desire to gradually normalize their monetary policies at a time when there is growing uncertainty as to the strength and duration of a two-year old globally synchronised reflation and when co-ordination of monetary policies is becoming more difficult to enforce. Less liquidity and reflation and less co-ordination implies higher volatility rates and greater chance of policy errors causing a potentially significant erosion of asset values.

It is not even clear where should one hide, as traditionally safe places (such as consumer staples) do not seem to be able to outperform their respective indices even at times of greater stress while higher priced technology sub-sectors do not sustain the type of erosion that one would normally expect at a time of rising cost of capital. Also, value is struggling to outperform both quality and growth, particularly in global portfolios, and despite rising oil prices, investors seem to be reluctant to fully re-rate energy stocks commensurate with strength of earnings revisions.

As we have discussed in our prior reviews, there seems little value left in conventional sector rotations, based as they are on conventional business and capital market cycles that no longer exist. The combination of technological disruption and the after effects of global overfinancialization (and resultant over-capacity and depressed cost of capital) essentially distorts and erodes traditional mean-reversion. Hence, certain sectors (such as consumer staples or media) are suffering from profound disintermediation while investors have limited confidence on durability of cyclicality and hence, are reluctant to re-price some of the cyclical sectors. This leaves companies that seem to be delivering growth trading at a significant premium.

…while correlations remain tight with limited dispersion as…

At the same time, investors’ expectations that the winding down of exceptional monetary policies would lead to much greater dispersion of returns is not translating into reality, with continuing high pair-wise correlations, whether one looks at individual markets or across markets. As discussed in our prior notes, we do not believe that investors would ever return to what is regarded as a conventional return dispersion; rather it is far more likely that extreme monetary uncertainty would be replaced by a mix of monetary, fiscal and political uncertainties, which are just as difficult to predict as were QEs and their impact. Hence, we do not believe that return of wider dispersions and conventional stock-picking markets is likely.

At the same time, reflecting investors’ uncertainty as to sustainability of the global recovery and ability of private sector to drive it, neither inflationary expectations nor relationship between bond yields and equities are reflecting strengthening inflationary background. In 1970s-90s, there was a strong negative relationship between bond yields and equities, reflecting markets’ consensus that central banks would vigorously step in to extinguish any (even tentative) signs of accelerating inflation and thus cause contraction of economic activity. However, since the late 1990s, the relationship between bond yields and equities has been mostly positive, implying investors’ concern that disinflation or deflation has become a far greater concern, and hence, rising bond yields were treated not as an indication of potential CBs over reach, but rather as a relief that deflation has been avoided. However, over the last six-to-twelve months, the correlations have become far more volatile, occasionally dropping into negative territory  (i.e. rising bond yields coinciding with falling markets) and sometimes returning back to positive relationship.

…investors struggle to see what type of inflation & reflation climate they inhabit…

Despite an overwhelming market rhetoric of inevitability of rising inflationary pressures, there are very few signs that inflationary pressures are actually picking up in any major economy or regional block. Even in the jurisdictions with generally higher inflationary pressures (such as US and UK), the outcomes, ranging from wages to core inflation, remain exceptionally benign. At the same time, Japan and Eurozone are continuing to skirt strongly disinflationary  outcomes while PPI pressures have largely dissipated in China. As can be seen below, despite having an apparently quite tight labour market, US real wages are barely expanding at 0.6%-0.7% while per hour wage growth for non-supervisory employees (82% of the US work force) is stuck at around 2.5%. Similarly, in the Eurozone wage  pressures remain mostly benign (expanding at ~1.5%-2% clip), and real wages are down in both China and Japan.

There is however an argument that while labour markets are globally so distorted that wage channel and conventional Philipps curves no longer function as they are supposed to, the commodities driven inflation could be a far more significant factor. Indeed, commodities are an even more complex phenomenon than wages, encompassing a wide field of factors, ranging from demand and supply to US$ and financial intermediation. The recent run-up in CRB  index (particularly oil) is prompting angst everywhere from the US pump prices to India and Indonesia.

We maintain our view that commodities generally have a negative influence, as much as they are a tax on countries, businesses and individuals, while concentrating money in the hands of countries with low propensity to consume (such as Russia or Saudi Arabia) and removing it from countries with high propensity to consume (such as the US or India). Hence, we are concerned that for a number of reasons, commodities could input too much inflation into global economies. Unlike 2014-15, when a collapse commodities caused a significant global deflationary shock, might a commodities run-up cause higher than expected inflationary pressures? Our view remains that it is possible, although such a run-up would eventually destroy the commodity complex itself as demand would be unlikely to accommodate much higher prices.

The key country that has a great deal of bearing on the final outcome is China. It was the last time when China  attempted to de-leverage in 2014-15 that caused the previous deflationary episode. On the other hand, it was also China that was the critical contributor to stabilizing and improving demand for commodities in 2016-17. As China attempts its third de-leveraging, would it provoke another collapse of the commodities complex? As discussed in our recent notes, we do not think so. We believe that it is far more likely that China would neither materially increase nor decrease its demand. This leaves supply as an argument for higher or lower prices. While it is subject to considerable uncertainty, we have never been great believers in supply side reforms. Since the 1960s, there have been only two supply-side shocks (i.e. 1973 OPEC increase in oil prices and recent shale gas revolution). However, in the absence of exceptional circumstances, supply of commodities almost always materializes from somewhere (if it is not China, it could be Australia, Brazil or Guinea). This then leaves US$ and financialization as the key remaining element, and we remain believers in generally stronger rather than weaker US$, and hence, this should moderate the underlying demand-supply side forces.

We thus remain convinced that CRB index would probably spend the year somewhere around 200, which implies that China’s PPI would probably remain at ~3%-4% and potentially lower in early 2019, whilst G3+China CPI would remain confined in relatively ‘goldilocks’ levels of 1.5%-2%. Thus, if neither wages nor commodities channels causes a significant displacement, then global secular disinflationary forces would probably become stronger as we approach  the end of the year, particularly late 2018/early 2019. It also implies that central banks won’t be able to continue tightening, as neither demand nor supply could afford higher cost of capital.

However, the danger is that if commodities run harder or wage inflationary channel delivers greater than expected shock, there would considerable flow-on impact on real growth and consumption. It would be clearly compounded by a much more hawkish CBs position.

As can be seen below, as 10Y bond yield approached 3%, 30Y mortgages exceeded 4.5%, and inevitably MBA re-financing index (the key support for consumption) has slumped to the lowest level since 2008/09. At the same time, nation-wide gasoline prices are now above US$3.2/gallon (and in some locations above US$4/gallon) vs closer to US$2/gallon only two years ago, while delinquency is already rising on both credit cards and auto loans, and as much as 25% of students loans are effectively unrepayable.

Given that the US is the single most important source of global end-user demand (here), and that it is largely a consumption-based society, these are exceptionally important trends. Apart from China reflating the commodity cycle, it was the ability of US consumers to maintain exceptionally low saving rates (sub 3%) that drove global revival. However, such low savings were made possible by rising net asset wealth of the US consumers and access to auto, credit card and student loans, which were all effectively supporting excess consumption.

In our view, it is hardly surprising that even as the Fed raises the short-end of the curve, investors are refusing to raise long-end, thus significantly flattening the yield curve, essentially implying a distinct probability of policy errors that would ultimately return the US and global economies back to a much more disinflationary climate. As can be seen below, whether we look at 2/10 or 2/30 or 10/30, the yield curves have reached historically lowest ever levels while the terms premium remains stubbornly negative, implying no investor believe in return of inflation.

The same applies to global rates and global inflationary expectations. Even in the case of the US, break-even rates today are only at levels that used to prevail prior to QE1. At the same time, real bond yields globally continue to gradually converge towards Japan’s levels (i.e. zero).

… particularly as most reflationary indicators are gradually slowing

Thus, equity investors are not sure whether they are in an inflationary, deflationary or stagflationary world—or indeed a mix of all three.

Most investors suspect that disinflationary pressures would remain strong and durable but just as machines are replacing humans, an avalanche of meaningless noise is overwhelming longer-term investment styles and hence, decisions are made at a fast speed based on short-term informational delta. It is quite possible that one could have a stagflationary  episode within a longterm deflationary channel. The picture is made even more complex by signs that global reflationary momentum, while not rolling over, is clearly slowing. This is evident whether we examine OECD leading indicators, global manufacturing output or trade.

Equity investors are looking at far more systemic asset classes, i.e. high yield, bond and currency markets to signal when and how much volatilities would rise on a more sustainable basis. As in Dante’s purgatory, investors are waiting to discover how many circles of ‘purification’ they would need to go through. Would pump prices, mortgage rates, student loans, US$ or EMs catch them, or is it possible that at least for a while the obvious and clear pressures and discontinuities can be avoided or at least delayed?